Insuring to “Value” & Coinsurance Clause

You’ve just purchased a new piece of commercial real estate. When it comes time to insure it, your insurance agent provides you with a commercial insurance quote in which the building replacement value is much higher than you actually paid for it. Since you invested a lesser amount into it, why would you insure it for more? You only want to be covered for what you actually paid for the piece of property.

Unfortunately, this is a scenario that plays out all too often. The market value of property ends up being far less than what it actually might cost to rebuild the building from the ground up. To understand this fully, it is important to define some key terms:

Market Value – the cost to purchase a property

Replacement Cost – the cost to rebuild a property using today’s construction methods and materials

To illustrate, let’s say a prospective property owner wants to purchase a building and the cost of the building was $1M dollars. It would stand to reason that the right amount of commercial property insurance would be $1M dollars. However, insurance companies require that a building be insured to replacement value, that is, the cost to rebuild that property from the ground up. Due to today’s market environment and rising construction cost, it would cost more to build the exact same building new, than to purchase existing.

Replacement cost is calculated differently by each commercial insurance company, but they all use a program similar to those provided by Marshall & Swift/Boeckh. These programs take into consideration variables such as construction type, square footage of the building, year built, number of stories, story height, intended use of the building, mechanicals, etc. The programs have pre-determined costs associated with each variable. When combined, they work together to determine an accurate cost to replace the building using today’s construction methods and materials. As a result, the same building you purchased for $1M dollars, may cost you $2M dollars to insure and the insurance company may require you to insure to the full $2M dollar replacement cost.

However, this is assuming a total loss of the building – i.e., it is completely destroyed. You don’t believe that your building would ever be completely destroyed because it is next door to a fire department, it has a sprinkler system, and it will be an office, so the chance of fire is fairly low. Because of that, you don’t think you’d ever have to fully replace the building and still want to insure it for $1M dollars.

Admittedly, total losses do not happen often. Because of this, insurance companies have implemented a coinsurance clause to entice property owners to insure their buildings to replacement cost value. The coinsurance clause is displayed in terms of percentages – often 80%, 90%, or 100%. Essentially, insurance companies require your building to be insured up to whatever percentage is shown on the policy. If you do not insure up to that percentage, a coinsurance penalty would apply. If a building is not insured to at least the required coinsurance amount and there is even a partial loss, the amount payable by the insurance company is reduced using the following method.

If the building replacement cost was calculated at $2M, and the coinsurance was 90%, the building must be insured to at least 90% of $2M, $1,800,000. In this case, the building was insured up to $1M dollars, so the loss is adjusted with the following formula:

In this example, if there were a $50,000 dollar claim and a $1,000 dollar deductible, the total payable amount would be $26,778 as determined by the formula below:

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